The price of gambling on Windows Phone 7

NEW YORK (CNNMoney.com) -- How Microsoft's new Windows Phone 7 fares over the next year will help answer a high-stakes question: Will manufacturers still pay for the software at the heart of their smartphones?

Before Google's Android operating system came along, there were essentially two options for handset makers: They could develop their own software for their phones, like Apple, Nokia and Research In Motion; or they could buy a software license from another company like Microsoft.

But Google (GOOG, Fortune 500) threw a wrench into those gears when it chose to give away its software for free. In contrast, Microsoft charges handset manufacturers about $5 to $10 per phone to license Windows Phone 7, Gartner analyst Ken Dulaney estimates -- a ballpark figure others in the industry back.

So why would handset makers and networks sign on -- as HTC, LG and Samsung already have?

As the old saying goes, "You get what you pay for."

Paying to license an operating system has its advantages: If something goes seriously wrong with the software, smartphone makers have essentially bought a "get out of jail free" card.

Windows Phone 7's license includes indemnifications protecting the handset manufacturers from legal battles, according to Al Hilwa, analyst at IDC. HTC and Motorola have been accused of patent violations by Apple and Microsoft, respectively, over the user interface on their Android-based smartphones. By paying a licensing fee to Microsoft, the handset makers essentially transfer the burden of fending off intellectual property disputes to the software maker.

"Ultimately, open source is free, but there is no neck to choke if something goes wrong," Dulaney said. "For that privilege, you have to pay someone."

"The licensing fees are such an insignificant component of the overall cost of the phone that it's not at all a factor in how we determine our partnerships," said Keith Novak, spokesman for HTC.

And Android isn't completely free either. Though there is no cost to the handset manufacturers to license the operating system, a source familiar with Android's licensing deals said Google charges smartphone makers for the applications that are pre-installed on Android phones, like Gmail and YouTube.Google declined to comment on the specifics of its licensing deals.

But other makers prefer to focus their resources on the platforms that are winning.

Microsoft (MSFT, Fortune 500) has been on a long losing streak with mobile, steadily giving up market share ever since Apple's iPhone burst into into the scene in 2007. Just 5% -- and falling -- of the world's smartphones were running Windows at this year's midpoint, compared to 17% running Android, according to Gartner.

Some of Microsoft's highest-profile past Windows Mobile partners have taken their chips off the table.

Motorola dropped Windows in favor of Android, and has done very well so far with its incredibly popular Droid, Droid 2 and Droid X smartphones. Hewlett-Packard was also noticeably absent at Microsoft's launch of the first round of Windows Phone 7 devices.

Carriers' dilemma: For carriers, the choice to add another operating system to their mix is more financially fraught than it is for manufacturers. Android, Apple's (APP) iOS, HP's (HPQ, Fortune 500) WebOS and Research In Motion's (RIMM) BlackBerry OS are all jockeying for position, and each one requires a customer service staff trained to troubleshoot it.

That support cost easily exceeds the cost of license fees, according to Dan Hays, a telecom analyst and partner at consulting firm PRTM.

Right now, AT&T (T, Fortune 500) and T-Mobile are the only carriers offering Windows Phone 7 devices, with the majority of the phones appearing on AT&T's network. Some analysts view AT&T's courting of Microsoft as a desperate search for a new stand-out device to keep phone sales steady should it lose exclusivity of the iPhone in 2011. The company is also the sole carrier for BlackBerry's closely watched Torch.

So will the cost of adding Windows to their product mix pay off for AT&T and the manufacturers who have adopted Microsoft's shiny new software? Stay tuned.

"The device payments may well be worthwhile in the end in terms of the fit and finish of the product, but ultimately, the market has to like the devices and software," said IDC's Hilwa.